Time To Abandon DryShips

Summary

DryShips has lost yet another contract from Petrobras that will have a negative impact on the company’s EBITDA performance.

DryShips has lost three contracts lately with a combined negative EBITDA impact of $7.9 million this year, which is bad news as its EBITDA slipped deep into the red recently.

DryShips investors should not expect a turnaround in China’s seaborne iron ore trade since the country is switching to electric-arc furnaces due to cheap scrap supply.

Things have gone from bad to worse for DryShips (NASDAQ:DRYS) in 2016 as the stock has already lost around 40% of its value. What's more, it looks like the bad news cannot just stop for DryShips as the company was hit with another contract cancellation earlier this week.

More weakness in the cards

On April 11, DryShips revealed that Petrobras (NYSE:PBR) has cancelled its contract for an oil spill recovery vessel that was contracted until August next year. As a result of this cancellation, DryShips forecasts that its EBITDA will take a hit of $2.9 million this year, which is not good news for investors since the company's EBITDA is already in negative territory.

In fact, in the fourth quarter of 2014, DryShips had a negative adjusted EBITDA figure of almost $15 million. As such, DryShips' EBITDA is set to sink deeper into the red as a result of this contract cancellation. But, investors should not ignore the fact that this is not the only contract cancellation that is going to pinch DryShips.

Over the past couple of months, DryShips has received another two contract termination notices, and both are from Petrobras. Last month's contract termination for the Vega Juniz, which was originally expiring in April next year, will negatively impact DryShips' EBITDA by $2.8 million. Meanwhile, the contract termination of the Vega Crusader vessel that came into effect last month will also set back DryShips' EBITDA by $2.2 million this year.

Now, these contract losses will be a big setback for DryShips as the company is already deep into the red. In fact, last quarter itself, it had posted a loss of $527 million along with huge impairment charges. In comparison, in the prior-year period, DryShips had a lower loss of $24 million. Thus, it is evident that the company's loss ballooned by a huge margin on a year-over-year basis, and this was a result of 96% decline in its revenue.

Now, given the company's recent contract losses and the fact that it has sold another three capesize vessels, DryShips will see further weakness in its financials going forward. Add to it the fact that the end-market scenario is getting worse for DryShips is another reason why expecting any sort of recovery in the company's performance is unlikely.

A weak end-market scenario makes a recovery difficult

The possibility of a recovery in the drybulk shipping market is weak. This is due to China, which accounts for a majority of the seaborne iron ore trade across the globe. What's more, due to the economic slowdown in China, the country's overall trade has taken a hit. For instance, during the month of March, China saw a drop of 7.6% in its imports, though exports increased 11.5% as compared to last year.

In comparison, China's exports were down 25.4% in February, so there is a lot of inconsistency in the country's trade on account of the end-market weakness. Now, looking ahead, it is likely that China's imports will continue to weaken as the country is reducing its consumption of iron ore. In fact, this year, it is expected that China's demand for iron ore will go down by 4.2%, driven by a 3.1% decline in steel production.

The decline in Chinese iron ore demand this year is far greater than the drop of 0.4% seen last year. Looking ahead, China's iron ore needs will continue to decline as the country's steel producers are increasingly installing electric arcs to produce steel. This is not surprising since the cost of producing steel by way of electric arc furnaces is lower than using coal and iron ore. As reported by The Chicago Tribune:

"The cost to China's mills of producing steel with ore and coal was about 2,130 yuan ($330) a metric ton last year, Bloomberg Intelligence calculates. Electric-arc furnaces spent about 1,853 yuan a ton. Scrap prices in China tumbled 48 percent last year, outpacing the slump in iron-ore, according to Metal Bulletin Ltd. data."

As a result, more steel mills in China are now moving toward electric arc furnaces in order to lower their cost base. As such, it is anticipated that by the end of the decade, 20% of China's steel mills will be using electric arc furnaces instead of the traditional method of using coal and iron ore in blast furnaces.

Therefore, DryShips will start seeing more weakness in China's iron ore trade, which is bad news for the company since China is the world's largest trader of seaborne iron ore.

Conclusion

Driven by weakness in oil prices and iron ore, shipping rates have taken a massive beating in recent times. Looking ahead, the likelihood of a comeback in China's iron ore and coal trade looks bleak, while investment cuts are being made in the oil and gas industry. As such, expecting a turnaround in DryShips shares looks like a bad idea, which is why investors should stay away from it.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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